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Blockchain: A Revolution or an Evolution?

Like many new technologies, blockchain began with the promise of a revolution in financial services. In 2016, however, 8 years after Satoshi Nakamoto published the paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”, the impacts are looking more evolutionary than revolutionary as financial institutions work together to realise the values and savings this technology can potentially bring.

What is blockchain?

The technology underlying blockchain is complex, but the principle it uses is simple.

Essentially, it is a record – or ledger – of digital transactions that is available to and shared by all those using it. It does this by using a software program for recording these transactions in a chain of information blocks – hence the name, blockchain.

When two parties wish to engage in a transaction, they must broadcast it to the entire network, effectively asking network participants to determine its authenticity before the transaction is allowed to be added to the chain. As everyone has a copy of the ledger, it removes the need for a trusted central counterparty to hold a single ledger of all transactions and to undertake the validation of new transactions.

Does blockchain signal the end for trusted intermediaries?

One of the revolutionary concepts of blockchain was the removal of trusted intermediaries from the transactional process.

However, the failings at Mt Gox in Japan in 2014 demonstrated that while you can remove a central trusted intermediary, this merely shifts the trust component to the access points (or ‘gateway’) of the Bitcoin ledger.

As Mr Hamilton, CEO of APCA, observed:

“Realistically, intermediaries will not disappear, so much as change in purpose and function”1

The ASX and Computershare are both investing in blockchain projects to gain back office efficiencies which demonstrate this process in action.

Mr Irving, CEO of Computershare is reported as saying:

“the focus should be on payments and trade settlement, not registry. The view that distributed ledger technology means everyone will get a copy of a share registry is naive”

“Computershare is not an intermediary in the traditional sense. Computershare is an agent for a critical end –user segment of the market”

“Only one trusted party can logically act as the gateway for the issuer for the purposes of maintaining issued share capital, otherwise the system will lack the integrity it needs on a distributed basis”2.

Mt Gox proved to be an unreliable gateway taking some of the blockchain hyperbole with it.

Like all existing financial markets, the need to provide sound governance and rules to deal with institutional failure and other market disruption events will still be required. This is because end users and regulators need to be given the necessary confidence in overall system stability in order for blockchain to operate as a mainstream system.

Recent progress of blockchain programs

Of all the blockchain programs on the table, Morgan Stanley3 have singled out “Ripple” as one project to watch. Ripple seeks to join domestic payment networks to enable cheaper and faster cross border transactions.

Smart, discrete uses of the technology to solve problems in an efficient and effective manner is where the current disruptive power lies in blockchain. These are the opportunities being explored by the industry. Morgan Stanley estimate that shared infrastructure will emerge over 2017-2020 with proliferation of blockchain solutions post 2021.4

Potential legal issues that could emerge with blockchain

1. Data and territorial jurisdiction

One of the biggest legal challenges for any blockchain system could be its distributed nature.

The very strength of its design from a security and assurance perspective may cause some of the biggest legal and regulatory challenges as it has profound implications for jurisdiction and the location of data. This is a big enough legal challenge for many organisations today, let alone given the addition of blockchain-based systems for storing and transmitting money and information.

Using the example of global banks making use of a blockchain-based ledger system, what is in the ledger of one bank potentially needs to be distributed to all other parties in the system (otherwise it would not be a true distributed ledger system). This is a big change from the current model, where each bank's ledger is unique to that bank.

However, in a blockchain system for settlement across multiple jurisdictions, there will be very large challenges regarding what information is sent where. This will have ramifications for data privacy, money laundering, securities licensing, currency regulations, financing of terrorism and organised crime and a whole host of related issues.

There are also a number of jurisdictions (most notably the US), which take a very broad view of the territorial application of their law. Given the scale of US capital markets, and the nature of where most cloud solutions are at some level hosted, it will be almost impossible in practice to design an international blockchain system (for just about any useful purpose) that is not compatible with US law.

However, that creates issues in itself where parts of US law (such as the Patriot Act) are potentially incompatible with elements of laws in other jurisdictions.

2. Controls on participation in a distributed ledger

Given their potential to disrupt the very lucrative businesses of centralised clearing and settlement systems, there is likely to be regulatory concern about the nature, identity and financial stability of participants in any blockchain-based clearing and settlement system.

This is a related issue to the one identified above – the jurisdiction problem. Any sense of “protectionism” from regulators seeking to defend the territory of their central bank could reduce the potential for gains from a distributed clearing and settlement system.

3. Contract law

Another of the touted benefits of blockchain is the emergence of “smart contracts”.

By including contract law principles into code design and operational protocols, the need for many contractual provisions can be made redundant as performance and/or validation becomes automated and conclusive.

In reality, so called smart contracts will simply make disputes rare rather than change substantive contract legal principles. The code design and protocols that establish the smart contracts will still need to comply with the contractual requirements of each jurisdiction in which it operates.

Coding errors, system disruption and data compromise events are all still possible (if not in the blockchain then at least at the gateway) as they are today in “trusted intermediary” systems. Each of these can give rise to disputes which will be determined in accordance with the relevant scheme rules, industry codes such as the epayments code, bilateral agreements and/or general commercial legal principles.

4. Competition law

Our major banks and other industry participants are working together in consortiums to harness blockchain’s potential across the industry. This is not unusual as our banks work together now to operate the Bpay Scheme and participate in the APCA clearing streams as well as the various card schemes.

This type of activity will always raise concerns with the ACCC as it has the potential to be anti-competitive conduct. Typically, these schemes seek an authorisation from the ACCC which it may grant if it is satisfied that the public benefit from the conduct outweighs any public detriment.

5. Deletion of data

One of the primary attractions of a blockchain-based system is that once data is incorporated in the chain, that data is fixed.

But what happens if there is then a legal requirement imposed that requires deletion of that data? As an example, the recent CJEU decision regarding the EU-US safe harbor rules may mean that some data held on US servers needs to be deleted. If that data was held in a blockchain system, this would be technically difficult, but could also undermine the very feature of blockchain that makes it so attractive.

None of this is insoluble with good design, but it will require careful consideration of how any blockchain-based settlement system operates day to day.

Ignore blockchain at your own peril!

Anyone who started in the financial services industry in the 80s will remember a time when the internet did not exist and no one had a mobile phone. Yet today, we can’t imagine life without them. Like all new technologies, a business will ignore blockchain at its own peril.

Whilst the revolution may be some time away, there is no doubt that the industry is investing significant resources to realise the benefits of this technology. Morgan Stanley research suggests this will begin to occur in 2017 and become commonplace from 2021, so the countdown has started!

So what should you be doing? 9 steps to take now

If your preparations for blockchain technology are still in their early stages, we would recommend that you consider taking the following steps soon:

Become engaged. Ignoring the technology will not make it go away. Create a focus within your organisation to understand and develop strategies for blockchain.

Identify areas in your industry and in your business that could be impacted. Any back office function that involves the transfer of assets can potentially be streamlined by blockchain by removing validation and escrow arrangements.

Think laterally. It is not just back office functions or those that involve a transfer of assets. Any record keeping process that needs validation or a high degree of certainty can potentially benefit from using blockchain technology.

Consider opportunities. Staying abreast of industry developments will enable you to position your business to be part of future blockchain programs.

Collaborate. Look to work with others and/or create interest groups.

Be prepared for failures. It does not always work the first time. But if you are going to fail then it is best to fail quickly and cheaply.

Manage regulator expectations. Where you are utilising new technologies, you need to ensure you meet regulatory requirements (such as APRA’s Prudential Practice Guide CPG 234 Management of Security Risk in Information and Information Technology).

Manage Risk. Disruption by new technologies is not a new risk. Ensure the matters arising out of the above activity are captured within the risk management system so that the potential size and impact of a ‘blockchain event’ are understood by your business. This will ensure that appropriate resources and focus can be applied to managing the emerging risks associated with blockchain.

Look for the black swan. There will be as much work being done in private as there is being publicly acknowledged. Expect surprises and consider how agile your organisation can be in adapting to sudden shocks.

While the disruption new technologies can bring is often seen as a threat, remember that it is also an opportunity. All financial services organisations need to be actively engaged in assessing blockchain if they are going to be positioned to take the best possible advantage of this new technology

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